The U.S. unemployment rate hit 14.7% in April. The economy is expected to contract at 30%-40% annualized rates in 2Q20. The price impact of the COVID-19 shock and lockdown was evident in April when the Consumer Price Index (CPI) excluding food and energy fell 0.4%, its largest monthly decline on record. Under these circumstances, protection against the risk of inflation is perhaps the last thought in investors’ minds. The risk of an unexpected jump in aggregate prices during the pandemic is minimal, as is the cost of insurance against such risk.
Over the longer term, levels of inflation near or above the Federal Reserve’s (Fed) 2% target are likely to return. Prices should remain in the doldrums as the reopening process unfolds and economic activity gradually resumes, but the oncoming migration towards more resilient supply chains will lead to an emphasis on local (rather than global) efficiencies, resulting in more expensive goods. Additionally, the policy environment is supportive of inflation; the Fed has implemented unprecedented ease and will tolerate higher prices to compensate for periods of muted inflation, while fiscal policy will likely remain active to stimulate aggregate demand. The prospect of future inflation and today’s low cost of protection against it suggest now may be the time to buy inflation protection.
For purposes of exposition, we organize the rest of this Strategy Insight as Frequently Asked Questions.
How will COVID-19 initially affect inflation?
The outbreak in China disrupted global supply chains, causing a negative supply shock. Negative supply shocks, all else equal, are by nature inflationary as the same amount of spending chases fewer goods. But all else is never equal, and as COVID-19 spread around the world, government-induced lockdowns to contain the spread curtailed spending and weakened demand. The disinflationary pressures that followed, further fueled by collapsing oil prices, dominated price pressures on the supply side, driving prices down. For instance, declines in apparel, motor vehicle insurance, and airline fares drove core CPI down 0.4% in April, its largest monthly decline since the series was created in 1957.
How do you think inflation will evolve in a post-COVID world?
We think there are three phases: (1) The COVID-19 shock and the aftermath; (2) a transition phase in which the reopening process unfolds; and (3) a post-reopening phase in which the economy settles into a regime where supply chains are more resilient, regional, and expensive. This regime is also characterized by economic policies supportive of higher inflation.
We are in the final stretch of Phase 1. As mentioned above, the net impact of the COVID-19 shock on inflation is negative. Within CPI, the most obvious victims of the virus such as airline fares and lodging, suffered steep price declines in March and April. The positive contribution of food at home and the impact of higher production and distribution costs were not enough to avoid negative monthly prints. Also, in this phase the output gap and the unemployment gap widened. Forecasts of Gross Domestic Product (GDP) declines between 30%-40% for the second quarter of 2020 are ubiquitous as are unemployment forecasts in excess of 20%, well above the 14.7% registered in April. The resulting economic slack will contain prices for the near future.
In Phase 2, although negative price forces will dominate, we also see a turning point for inflation. Businesses will reopen, albeit with limited capacity to implement social distancing and other enhancements to health practices in the workplace. These adjustments will increase unit costs and contribute positively to prices, but not enough to offset continuing negative demand pressures. We expect the unemployment and output gaps to stabilize in this phase, but the level of economic activity and spending will not be enough to fully reverse price trends from Phase 1. Moreover, if the fear of infection lingers, or confidence is not restored, businesses may be forced to offer deep discounts. In this phase, the arrival of a successful treatment or vaccine would provide a boost to confidence, accelerating economic activity considerably, but this is something that is more hope than reality, and hence we treat it as an exogenous event.
In Phase 3, the economy enters a new paradigm. The shape of this post-COVID economy is uncertain, but it will exhibit two characteristics. First, the era of trade expansion and globalization as we know it will be over. Businesses will be forced to operate with more predictable and resilient supply chains; i.e., shorter, diversified, and more domestic. Cost minimization will be harder, subject to stricter health and safety controls, and tighter geographies. This will make goods more expensive. Second, monetary and fiscal policies in place will support building inflation pressures. We expect the Fed to adopt average inflation targeting, tolerating above-target inflation for an extended period to compensate for stretches of low or non-existent changes in aggregate prices. Furthermore, the coordination of monetary and fiscal expansion experienced as COVID-19 broke out will remain in place for a long time. One factor influencing an active fiscal policy will be an increased need to alleviate the disproportionately harder impact of the pandemic and the recession on medium- and low-income groups. (The Appendix summarizes these phases.)
How about the perception of the public? Are inflation or deflation concerns more important today?
For a real-time assessment of general public concerns, we looked at data from Google Trends. A value of 100 in the exhibit denotes the month with most searches for either inflation or deflation in the 12-year window starting January 2008. Note that there are three distinct peaks in searches for deflation: November 2008, August 2010, and January 2015. The Global Financial Crisis (GFC) elicited the highest number of searches. Interest in deflation has noticeably increased, not to levels seen around the GFC, but relative to recent years. Searches for inflation peaked in April 2008 and stayed above 50% of that mark ever since, breaking 90% in 2010 and 2018. Interest in inflation does not seem different today from several prior years.
Is inflation or deflation protection more costly today?
The most direct answer is found in the inflation derivatives market. A 2-year, 2% CPI cap pays out if CPI inflation is above 2% in 2 years. Similarly, a 2-year, 0% CPI floor pays out if CPI inflation is below zero in 2 years. Today, the cost of inflation protection (cap) is a fraction of the cost of hedging deflation risk (floor), especially using shorter horizons. The contrast is most stark for 2-year caps and floors, where inflation protection is almost free, at 1/60 of the cost of deflation protection.
How can bond investors protect against the risk of future inflation?
Investing in Treasury Inflation Protected Securities (TIPS) provides such protection. When investors buy TIPS, at maturity they collect the principal amount plus cumulative headline CPI inflation accreted over the holding period. What if cumulative inflation over the life of the bond is negative? TIPS principal payments at maturity are subject to a deflation floor; i.e., at maturity, TIPS investors receive the greater of par and inflation-adjusted par. As an illustration, consider $100 million in a 5-year zero-coupon inflation-protected bond. If cumulative inflation over the life of the bond is 3%, it pays $103 million at maturity. But if cumulative inflation over the life of the bond is -1%, it pays $100 million, not $99 million.
How is TIPS performance against that of nominal Treasuries measured?
We track the difference between nominal Treasury yields and TIPS yields (real yields). This difference is known as the breakeven rate of inflation, as it denotes the inflation rate that would make investors indifferent between a nominal Treasury bond and an inflation-protected Treasury security of identical maturity. An increase in the breakeven rate of inflation means that TIPS are outperforming nominal Treasuries, which could occur if real rates rally more than nominal rates, or if real rates sold off less than nominal rates.
Where are breakeven rates today and how were they affected by COVID-19?
Today, the 10-year breakeven rate at 1.10% is almost 70 basis points1 below the year’s high. This rate usually moves around the Fed’s 2% inflation target, and on average close to long-term levels of realized U.S. inflation such as headline CPI and core CPI. The COVID-19 shock caused the 10-year breakeven to drop 60 basis points in March. It has recovered some ground, but considering demand conditions that will suppress inflation in the near term, breakevens are still well below their historical levels, offering an attractive entry point for TIPS investors.
Why do you think current breakevens signal attractive opportunities in TIPS?
Consider the historical performance of TIPS relative to nominal Treasuries as a function of the breakeven rate at a point in time. The exhibit on the right shows that low levels of the 10-year breakeven rate at a point in time (horizontal axis) are associated with positive cumulative TIPS excess returns in the subsequent 3 years (vertical axis). For instance, every time the 10-year breakeven rate hovered around 1.5%, TIPS outperformed nominal Treasuries in the subsequent 3 years, as breakeven rates moved back to higher average levels. Analogously, breakeven levels above 2.25% were followed by TIPS underperforming in the subsequent 3 years, as breakevens moved back to lower average levels. This suggests that breakevens tend to revert to their trends following abrupt deviations. As noted above, inflationary pressures, over time, will offset current downward pressures on prices that drove breakeven rates down. With breakevens today around 1.10%, there is potential for TIPS to outperform nominal Treasuries.
With the effect of the COVID-19 shock still strong, inflation is not at the forefront of investors’ concerns. That is why the cost of protection against inflation is near its lowest levels ever. It is for this reason that now is the time to make new or increased allocations to TIPS. Inflation protection may seem unnecessary given today’s economic conditions, but it will become an important asset as supply chains become more resilient, at a time when coordinated fiscal and monetary policies will be actively stimulating demand. Furthermore, future inflationary pressures will find a Fed that is more tolerant of inflation, willing to let it run above target to keep real rates low, and to compensate for periods of low inflation. Compelling valuations and a supportive policy environment create an almost ideal time to invest in TIPS. If not now, when?
Jorge Aseff, PhD
Head of Quantitative Research
Douglas Mark, CFA
TIPS Portfolio Construction and Trading
Issuers with credit ratings of AA or better are considered to be of high credit quality, with little risk of issuer failure. Issuers with credit ratings of BBB or better are considered to be of good credit quality, with adequate capacity to meet financial commitments. Issuers with credit ratings below BBB are considered speculative in nature and are vulnerable to the possibility of issuer failure or business interruption. Opinions, forecasts, and discussions about investment strategies represent the author's views as of the date of this commentary and are subject to change without notice. References to specific securities, asset classes, and financial markets are for illustrative purposes only and are not intended to be and should not be interpreted as recommendations.
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1 A unit that is equal to 1/100th of 1% and is used to denote the change in a financial instrument